What is Trend Reversal ?

A trend reversal happens when a stock (or any instrument of financial trading) changes direction and moves in the opposite direction. Examples of trend reversals are upward trends which reverse into downward trends and downward trends which reverse into upward trends. 

Bullish/Bearish Trend Reversal

Bullish market reversal or uptrend occurs when price activity tends to bring consecutive higher highs and higher lows. When the stock stops making higher highs, a bullish reversal emerges and starts to make lower lows and lower highs thereby changing the course from up to down. A reversal of the bearish trend follows the same lines in reverse. A downtrend is the bearish price action, whereby the stock produces lower lows and lower highs. Each bounce attempt is sold forming the lower high and each preceding low becomes harder to sells to make lower lows. When the price no longer makes lower lows and forms a higher low, and keeps rising with higher lows and higher highs, a bearish trend reversal has been formed.

The Challenges of Spotting a Reversal

Simply put, when a market changes momentum and begins going in the opposite direction from prior price activity, a reversal has happened. Psychologically, it can be extremely difficult for even the most skilled investors to respond to reversals. That’s because the sector already shows multiple signs of a continuing push in the initial direction in the early stages of a turnaround. 

The 2008 market crash was a perfect example of a dominant downtrend that was hard to detect at the end. While the lows of March 2009 are easy to find with the advantage of hindsight, it was significantly harder to go on long stocks in 2009 after the market had already so severely punished bulls in the previous year. 

The Challenges of Spotting a Reversal

By the time skittish mainstream investors had stacked up on the stock-buying bandwagon, a large portion of the original push from the market was already behind it. Improving understanding and spotting of the reversal is one solution to something like this. 

Markets aren’t always trending, of course. Markets can trade quite often without a discernible direction. It is also important to spot reversals in a variety of markets; not only do reversals tell you when a new pattern is about to begin, but they may also be a more interesting trading opportunity for more active traders in the short term.

Importance of Spotting Trend Reversals

The value of spotting pattern reversals are

  • First, it facilitates timely exits to secure assets or to prevent losses.
  • Second, it provides the dealer with an opportunity to take advantage of trading in the opposite direction as the pattern is reversing.

Anticipation Versus Confirmation

There is also a thin balance between receiving clarification and expecting the reverse. For a bigger profit gain, anticipating can get you an earlier entry on the reversal, however, the risk of getting faked out remains, which can result in a loss. Entering the trade on confirmation can result in chasing the entry too far, leading to a minimal profit and still a possibility of being stopped low on the reversal. The game plan can be sound but the results are in proper trade execution. Typically, waiting for approval is safest, and then waiting for the first attempt at reversal to walk into the trade near the reversal support zone. There are many ways to identify a reversal of the trend.

Method 1: Trend Lines

Trend Lines

Trend lines are a common visual tool for spotting patterns and reversals. This requires some additional work in advance of time drawing the trend lines and involving careful tracking. 

How to draw trend lines? Here’s how: begin from the highest high on the defined chart and link to the lowest high to form the upper trend line. Start with the lowest low and link to the highest low, to draw the lower trend line. To create a more stable pattern and range it is important to try to get sequential high/lows to link to the trend lines.

Significant Elements of a Trend Line 

The channel reflects the difference between the upper and lower trend lines. An upward trend is the widening of trend lines with higher highs and higher lows, while lower highs and lower lows with all trend lines dropping diagonally suggest a downtrend.

How to Detect Trend Reversals on a Trend Line

Trend reversals can be horizontal or diagonal. If all trend lines travel up or down diagonally together, then they are in an active up/downtrend. The trend reversal occurs as the market’s opposite trend line is disrupted and is then followed by higher highs and higher lows for a downtrend reversal to a breakout and lower highs and lower lows for an uptrend reversal to a breakdown. 

If all trend lines are horizontal then this indicates a convergence that will ultimately result in a breakout or breakdown. If the upper trend line is sideways with a lower trend line diagonally rising, then a possible ascending triangle breakup is emerging. If the lower line of trend is horizontal with the upper line of the trend moving diagonally it reflects a descending triangle with a possible breakup. When the lower and upper trend lines travel in opposite diagonal directions forming an apex, then a possible wedge or symmetrical triangle would form.

Moving Averages

Moving Averages

One of the most common metrics for monitoring trends is the moving averages. A mixture of two moving averages, a lead and a laggard (Ie.: 5-period and 15-period moving average) are typically used. Once the lead passes the laggard, either upwards or downwards, they form a breakout or collapse and follow, respectively, with an uptrend or downtrend. The larger the moving averages, the more strongly the trend emerges with lesser wiggles. 

Important moving averages most widely used variation is the 50-period and the 200-period moving averages. These are the components of the bullish golden cross breakout that occurs as the moving average of a 50-period passes up through the moving average of a 200-period. The bearish death cross breakout occurs as the moving average of 50-period falls down into the moving average of 200-period producing a downtrend. Shorter time periods such as the 5-period and 15-period are commonly used intra-day.

Method 3: Volume Weighted Moving Average (VWAP)

The weighted volume moving average (VWAP) is a single moving average representing the prices where the most volume was traded that day. Usually, it is followed intra-daily. Institutions use the VWAP as a measure of how well their orders filled out relative to the market. Traders should use the VWAP as a single support or resistance thread, as well as an all-day indicator of movement. If a stock moves over a declining VWAP, then a trend reversal may be happening. Usually, this is confirmed on the pullbacks which then deflect back from the VWAP as it turns up, and vice versa on uptrend reversals when a stock drops below VWAP and then rejects bounce attempts on the VWAP line as it begins to decline, indicating an upward trend reversal turning into a downward trend.

Method 4: Long Term Chart Patterns

Many of the more common long-term trends are gradually established and include a bottoming cycle or a sequence of repeated attempts at reversal.

Cup and Handle pattern

Cup and Handle pattern

A bullish cup and handle emerges from a top, the edge, or lip, where a stock experiences a heavy sell-off. Eventually, the price forms a rounding bottom indicating that there are no sudden swings but a steady sequence of higher lows and lower elevations that form the foundation and consolidation. The reversal eventually takes shape slowly as the stock rises back up towards the area of the lip. This forms a U, the cup. In slow diagonal motion, the handle, the stock will re-test the lip and reverse back down again. Then, the stock bounces fast along the upper trend line, this time it tears through the previous highs (the lip) and squeezes higher on the up curve for the next run.

Head and Shoulder Pattern

A bearish head and shoulders pattern forms after having an initial peak followed by a first shoulder pullback. The lows of the pullback start the trend line. So the stock succeeds in going higher through the previous high to create a new high before peaking, this is the Head. The stock pulls back, then bounces up again. The low of the bounce area is the shoulder line where you connect the trend line. This rebound merely brings up a modest recovery that fails to exceed the level of the head area. It forms the second shoulder when the stock peaks out. The shoulder trend line is the key spot to watch as the stock reverses back downwards. When the trend line breaks, it triggers the cycle of a head and shoulders trend whereby investors have lost momentum and profit takers and short-sellers take over, allowing the market to fall into a downtrend on trend reversal.

Head and Shoulder Pattern

How to Trade Trend Reversals

In the reversal process, trend reversals can be traded at different stages. It is important to hold trailing stops when there are trading reversals in case the reversal turns out to be a headfake. Reversals tend to begin as wiggles or reversals fail to bounce and ultimately reverse the trend. The reversal point is the point at which it breaks out or breaks down. The opposing trend then follows. An upward trend will eventually peak. As it tries to bounce again, stronger selling pressure produces lower lows and lower highs to finally collapse support with a breakdown and downtrend forms.

Increasing Profitability on Reversal Bets

Since finding reversals is not foolproof, smart risk management strategies are critical to prevent getting hammered if a possible reversal fails. The best way to do this is to have well-placed stop losses just below the trend line for the stock. 

Reducing your position size is another excellent way to minimise your risk exposure in very volatile markets and restrict the amount of drawdown you see when searching for trend reversals. 

Seek not to “top tick” a reversal by betting against stocks when they are still in uptrend movement. A price breakdown will also be a trading warning to you. Rather, wait until the reversal finally occurs and then catch the meat of the transfer. Although being reactionary will lose you several points on either side of the exchange, it will increase your success rate significantly. Though detecting reversals early will greatly increase the ability to benefit from both bull and bear markets, mastering technical analysis is possibly one of the toughest (and most sought-after) skills. Practice is, as in most disciplines, is essential.